Super-size me: The risk of going too big in bonds

The fallout in fixed income markets following the departure of Bill Gross from “mega manager” PIMCO has added a new dimension to the challenges facing fixed income investors. The bond market’s concerns of the last few weeks are noteworthy, and mostly justified, but should also be viewed as an opportunity to reflect on portfolio strategy, liquidity risk and firm risk.

At this stage of the cycle, moderate size positions and capacity sensitive asset managers are most likely sized for success. The risks of going big and being wrong have never felt greater.

Fixed income investors face some big challenges - low and potentially rising interest rates, poor liquidity and now this shake-up at the top of the asset management world. The result has been increased uncertainty, volatility and downward pressure on asset prices. Several strategies can help mitigate these risks: focusing on the most attractive parts of the market such as corporate bonds; recognising liquidity constraints posed by mega managers; and utilising market disruptions that don’t have lasting effects as investment opportunities.

The case for exercising caution around interest rates is strong, but investors shouldn’t paint all bonds with the same brush. Federal Reserve policy makers appear set to conclude their large scale asset purchase programme (quantitative easing) in October. Last month, they increased their median forecast for the funds rates to 1.38% at the end of 2015, 2.88% by the end of 2016 and to a “neutral level” of 3.75% by the end of 2017 [1]. But while government bonds appear largely unattractive across most developed markets, corporate bonds still offer reasonable yield premiums with attractive credit fundamentals, moderate risk profiles and historically low default rates. Moreover, the corporate bond sector offers a rich seam for right-sized, research driven firms to uncover value, assess risk and add alpha to client portfolios through security selection.

A further challenge for bond investors is liquidity — the ability to transact and the cost of doing so. Liquidity has deteriorated in recent years as the industry experienced dramatic change post the financial crisis.

There are fewer broker dealers on the sell side, and firms still in business face higher capital requirements that reduce profitability and the incentive to carry a large inventory of bonds, while traders are socked with punitive charges for holding bonds too long. Finally, new regulations related to proprietary trading versus market making create another layer of uncertainty. The days of counting on the sell side to help provide liquidity in the bond market are gone.

Changes in the asset management industry have also contributed to the decline in fixed income liquidity. Several bond managers experienced massive growth in assets under management, surging well in excess of $1 trillion. As a result, a small number of fixed income managers now oversee a large percentage of assets.

Liquidity is usually less of an issue for managers buying and accumulating bonds, but it becomes more of a problem when managers need to sell. The problem escalates when a mega manager needs to sell a large position due to a change of strategy or significant investor redemptions.

The combination of fewer broker dealers and XXL-sized asset managers can put significant downward pressure on individual bonds or entire sectors that are being liquidated. The important point is that reduced liquidity increases transaction costs and hinders alpha generation, especially in larger size portfolios. Buying into a mega manager can hurt you on the way in, on an ongoing basis (due to greater difficulty fully exploiting security selection strategies) and on the way out.

Though no firms are immune to liquidity challenges, right-sized asset managers - those large enough to have deep research resources, but not so large they can’t to be nimble and impactful - appear best positioned to weather liquidity storms. Recent market dislocations, driven by concerns related to one super-size manager, may in fact be creating attractive opportunities for long-term investors who can selectively buy at cheaper prices in investment-grade corporates, high yield, mortgages and asset backed securities.